Charles A. Jaffe: How index funds fare as stock like GM's dies

The stock market and the economy certainly have people talking. They have my readers asking questions. Here are a few good ones about the fund world:

From John in Seattle. I saw that General Motors is out of the Dow Jones [industrial average] and [Standard & Poor's] 500. Does that create a problem for my index funds? What happens when a big stock just drops off like this?

Answer. Bankruptcy is a deal-breaker for virtually every index there is, so GM didn't just fall out of the Dow and S&P, but is out of just about every index you can think of.

With that in mind, it must also be out of funds based on those indexes.

While investors typically think of index funds as "passive" investments that simply mirror the benchmark, there are plenty of times when index-fund managers get busy swapping out stocks that have fallen off for newcomers that have been added to the mix.

Some indexes, such as those run by Russell, go through a regular "reconstitution," where the keepers of the benchmark make changes to the holdings so that their index better reflects the current market. Stocks can also just fall off the index because of merger, bankruptcy, growth (too big for a small-cap index) or shrinkage (too small for a large-cap index); some indexes - such as the Dow and S&P - make immediate replacements when bankruptcy knocks a stock like GM off their list, others (like the Russell indexes) wait until they make semiannual changes.

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For the most part - aside from the loss suffered during the stock's decline - it is a nonissue for index-fund shareholders. Their fund manager basically has "a reasonable amount of time" to unload shares. Some may have made the move once bankruptcy for GM appeared to be imminent and inevitable; some will try to eke out a few extra pennies if the stock bounces back on the Pink Sheets based on news about the company.

How smoothly managers unload their shares will help to determine how closely the index fund tracks its benchmark. Indexes have no trading costs, but index funds do; those expenses come off the top and are part of the friction that typically forces the fund to lag the return of its index.

(The delisting of GM pushed it off indexes, but the process has been ongoing for a while. A decade ago, the stock was on the Russell Top 50, Top 200 and 1000 indexes; it dropped off the Top 50 in 2000 and fell out of the Top 200 in 2008 before falling out completely with its bankruptcy filing.)

Once GM emerges from the bankruptcy process, it may rejoin some indexes, but fund managers will not hold on to their current shares hoping to avoid transaction costs if there's a quick turnaround.

"There are too many uncertainties for the manager of an index fund to hold on," said Jason Hsu, chief investment officer of Research Affiliates, which develops fundamental indexes. "It most likely will come through bankruptcy as a new stock, with new shares, and the old shares will have no value, so while GM could come back to the indexes when it is out of bankruptcy, managers can't assume it will be the same GM."

From Mike in Memphis. GM has been sick for a long time, so why couldn't an index-fund manager have just gotten rid of it a long time ago? Their fund would have done better without it.

Answer. There is no question that a manager could "enhance" an index by getting rid of the dogs that make the cut. Had you cut the Standard & Poor's 500 down to the S&P 499 by eliminating General Motors in 2007 or 2008, there's no question that performance would have improved.

But that would be active management. You'd be adding a layer of active decision-making, which raises costs. And once you step onto that road, you're not just talking about one ill stock, but you start wanting to weed out any investment that creates concern, and then judgment starts coming into play.

Active managers have a long record of struggling to beat their benchmarks, so even an "enhanced index fund" – which is mostly index with an active component thrown in – should be considered carefully. If you want active management, get a strategy you can believe in; if you want exposure to an index over time, buckle up on appropriate index funds and go along for the ride.